Barry Dolowich

Q: My husband and I own a second home locally. We purchased the home over 20 years ago for $150,000. Over the years, we refinanced many times and currently have recourse mortgage debt of $600,000. Unfortunately, the property's fair market value today is $350,000. We have the opportunity of selling the property in a "short" sale for $350,000 with the consent of our lender or just letting the property go by way of foreclosure. Keeping the property is out of the question, because we can no longer afford to make the mortgage payments. From a tax perspective, does it matter if we go through with a short sale or allow the property to be foreclosed?

A: Unfortunately, it appears that you may have serious tax issues, regardless of which path you choose. Let's walk through both scenarios.

Scenario 1: The short sale.

A short sale is the common terminology used when a property, with the agreement of the lender, is sold for less than the loan amount. Assuming that your lender does not pursue any of your other assets, you will be receiving a Form 1099-C, Cancellation of Debt (COD) of approximately $250,000 (debt of $600,000 less $350,000 short sale price — Note: I am ignoring the tax consequences of any closing costs). The cancellation of debt in the amount of $250,000 will be taxable (in full or in part) to you as ordinary income unless the debt has been discharged in bankruptcy or you were deemed insolvent when the debt was canceled.

In addition to the COD income of $250,000, you may also have to recognize a long term capital gain of $200,000 representing the difference between the selling price of $350,000 less your tax basis (cost) of $150,000.

Let's assume that at the time of the short sale you are insolvent by more than your COD income of $250,000. Claiming this exception, none of the COD income of $250,000 would be taxable. However, you would be required to reduce your tax basis of the property by the amount utilized in the insolvency exception (but to not less than zero). Your tax basis in the property would be reduced to zero (original basis of $150,000 less $250,000 insolvency exception). Therefore, your long term capital gain would be $350,000 (selling price of $350,000 less zero tax basis).

Scenario 2: Foreclosure.

Under this scenario, you will be receiving two forms from the lender, Form 1099-C (Cancellation of Debt) and Form 1099-A (Acquisition or Abandonment of Secured Property). The COD income in this case will be determined by the difference between the debt owed and the fair market value of the property as determined by the lender. The Form 1099-A will provide the fair market value of the property which will be used by you as the "selling price" for purposes of calculating the long term capital gain. Assuming the lender uses the same $350,000 as the fair market value of the property, the tax ramifications will be roughly the same as in Scenario 1.

Barry Dolowich is a certified public accountant in Monterey. He can be reached at 372-7200, P.O. Box 710, Monterey 93942-0710 or bdolowich@aol.com.